WTI, Brent, Dubai as Oil Price Benchmarks: Caveat Emptor

There are more than 130 varieties of crude oil and WTI (West Texas Intermediate) is not even the benchmark used to price most of the crude traded in the world. That distinction belongs to Brent, a UK blend of oils from the North Sea. Brent is used for pricing 2/3 of the world’s traded oil. WTI is mostly used for pricing oil consumed in the U.S. What makes these two crudes so special and, in the media’s eye, WTI even more so?

Not all varieties of oil can serve as a benchmark, or marker crude, for all other crudes. Only 3 of those varieties make the cut based on their quality and location: WTI, Brent, Dubai Fateh. WTI and Brent are sweet, light crudes – the most sought after type of crude due to its relative ease to refine. “Sweet” means low sulfur content – the opposite is “sour”. “Light” means having a low specific gravity, or density compared to water – the opposite is “heavy”. The American Petroleum Institute (API) defines light crudes as those with a specific gravity of 31.3 degrees or higher. If an oil’s specific gravity, or API gravity, is greater than 10, it is lighter and floats on water. However, a crude can’t be too light – crude above 45 degree API gravity contains fewer of the compounds desired by refiners – such as high octane gasoline and diesel fuel. Gasoline refiners prefer WTI while diesel refiners prefer Brent, which is slightly heavier.

Lower quality crudes, such as Dubai (known in the UAE as Fateh), are usually priced at a discount to light, sweet crudes with an adjustment made for location. Dubai Fateh, a medium, sour crude, serves as the benchmark for crude oil destined for Asian markets, despite its lower quality, because of its immediate availability to the region. Dubai Fateh futures contracts are traded on Dubai Mercantile Exchange and InterContinental Exchange (ICE). WTI serves as the benchmark for oil consumed in the Americas. Brent serves as the benchmark for oil consumed in Europe, Africa and occasionally North America. Most WTI futures and options trade on NYMEX, with some trade in ICE. Brent trades mostly on ICE, with some trade in NYMEX.

What makes WTI so prominent in the world media? First, WTI is the highest quality crude there is. Malaysian Tapis comes second, with even lower sulfur content, but its API gravity lies above 45. Second, the transparency and frequency of data on WTI prices and their underlying supply and demand fundamentals make WTI a superior heuristic more often than not. Data on Brent oil stocks, for example, are considerably less accessible to the public, whereas WTI stocks are reported on a weekly basis by the EIA. Third, WTI is the benchmark for crude consumed in the U.S., the world’s porkiest oil consumer, accounting for ~25% of global oil demand. Fourth, WTI has the most actively traded oil futures contracts in the world. In 2008, 134,674,264 WTI futures contracts traded on NYMEX alone versus 68,368,208 Brent futures contracts that traded on ICE. WTI by far beats Brent for the largest paper oil market in the world by trade volume. Other crudes, such as sour urals crude, have illiquid paper markets and mostly trade in the physical markets, where spot price data is hard to collect on a timely basis.

So there are some compelling reasons for WTI’s preponderance in the media. But there are growing signs of its obsolescence as well. Local demand issues can sometimes influence WTI to the degree that WTI no longer represents world oil market conditions. Though oil demand is indeed collapsing all over the world, it’s not necessarily collapsing to the same extent as WTI. Crude stocks outside the U.S. have been falling while those inside the U.S. have been rising (Chart 1). The shortage of oil storage in Cushing, Oklahoma – the delivery point for the WTI futures contract – has led to a sharp drop in WTI such that it now trades at a discount to Brent – more on WTI-Brent price dynamics later. As LCM Commodities’ Ed Morse observed: “WTI is a landlocked crude oil without access to a waterborne market to relieve the surge in inventories, meaning that only an increase in demand from Midwest refineries or lower regional supplies would reduce stockpiles. The construction of pipelines to move oil from Cushing into the US Gulf of Mexico would also reduce supplies.”

Distortions also present themselves in the composition of oil supply in those Cushing stockpiles. A growing portion of the oil in Cushing storage is not WTI. Cushing has become a way station for oil from Canada, particularly those unconventional sources, tar sands, that produce heavy crude. So WTI prices no longer represent just the very best quality crude to which lesser crudes are discounted. Moreover, Cushing oil stocks only amount to about 35 million barrels out of the c.300 million total U.S. stocks as of November 2008. In terms of quality and quantity, WTI no longer faithfully depicts the world oil market. It doesn’t even faithfully depict the U.S. market: There are other kinds of light, sweet crudes used in other parts of the country, but NYMEX chose to focus on WTI oil stored at Cushing, Oklahoma and sent to the American Midwest market. WTI most accurately portrays local supply and demand conditions in the Midwest.

Is it time to stop obsessing over WTI and move on to Brent as a proxy for the world oil market? Brent is the second most transparent market, with high derivatives trade volume. 2/3 of the world’s traded oil is benchmarked to Brent prices. Historically, Brent has traded at an average discount of $1.48 per barrel to WTI between 1987 and 2009, but the tables have turned: Brent is more and more often finding itself at the top of the oil market totem pole (Chart 2). Between May 1986 and February 2009, 73% of the days that Brent fetched a higher price than WTI occurred after 2000, 40% in just the past two years. The standard deviation in the WTI-Brent price spread has increased in the past 8 years from $1.45 in 1986-2009 to $2.06 in 2000-2009. On February 12, 2009, Brent saw its highest premium ever of $10.58/barrel (closing price) over WTI, though it did hit an intraday high of $11.56/barrel on January 15, 2009.

BUT… Brent has issues of its own as an oil marker: It, too, can give a distorted view of the global oil market as local factors overshadow global factors. Brent production has fallen to a few hundred thousand barrels a day. The strength of Brent prices may be reflecting its increasing scarcity, not necessarily the global supply and demand balance. Diesel is, after all, becoming the fuel of choice for the world outside the U.S.. However, Brent doesn’t have a monopoly on diesel compounds – refiners are increasing capacity to refine sour crude.

If it weren’t for their inefficient price discovery, sour crudes destined for Asia would be a more accurate indicator of world oil market dynamics. China is the second largest oil importer behind the USA and accounts for nearly 10% of global oil consumption. China – and emerging markets in general – drive most of world oil demand growth and what kind of crude do they buy most? Sour crude. Asia just opened complex refineries that can process those hard-to-crack crudes (pun intended) and plans to build more. The rise in demand for sour crude, along with OPEC production cuts, pushed Dubai crude prices higher than Brent for the first time ever on January 6, 2009. Not only is sour crude seeing more demand growth, it also outstrips light, sweet crude in production growth. Most of the world’s remaining oil supply is sour or heavy, so its share in world oil production is likely to increase as light, sweet crudes go extinct. Until we can cast a wide, real-time net on sour crude prices however, we’ll have to settle for WTI as a shortcut to world oil market conditions.